It’s Hysteresis, Stupid.

The US economy reached a significant milestone in May when the number of employed Americans returned to the peak recorded before the advent of the global financial crisis.

Considering that the recession in the US officially ended back in 2009, it has been a slow and tortuous recovery.

Actually, May’s milestone was not an occasion to celebrate.

What was more important than the number in work was the obverse – the number out of work.

Since the financial crisis began back in 2008 the US population has increased by 15 million. To restore the ratio of employed to the total eligible to its pre-crisis level would require another 6.9 million jobs to be created and filled.

Even then the national workforce would be inferior to the pre-crisis condition in that most of the new jobs would be in the low-paying service sectors. Their contribution to consumer demand would be significantly less had the composition of employment returned to its pre-crisis structure.

For investment to return to its pre-crisis trend line would require the US to successfully push its way into export markets.

The problem there is that there are 20 or so other developed economies with the same challenging economic fundamentals as the US.

Most of the developed economies – Australia being one of the few exceptions – are exhibiting worrisome symptoms of “hysteresis”.

What is hysteresis?

Hysteresis, not to be confused with hysteria, refers to the dependence of the output of a system not only on its current input but also on its history of past inputs.

In the US labour example cited above, the degree of participation in the workforce has fallen significantly since the advent of the global financial crisis. The GFC is not the only factor that has changed the attitude of so many Americans disengaging from the labour market, but it is certainly the most obvious one.

Other factors could include automation, globalisation or simply ageing.

The depth and duration of the Great Recession (as it is referred to in the northern hemisphere) along with deployment of austerity as a fiscal strategy and near zero official interest rates have characterised the GFC as being qualitatively different from the mainly cyclical recessions of the post-World War 2 era.

However, modern research has widened the field of knowledge and experience of different economic crises beyond recent history.

Studies of deep depressions in earlier times have identified the highly persistent effects of hysteresis-influenced inputs on long-term output.

And as Lawrence Summers, an economist of academic distinction who has had practical policy experience at the highest level, remarked back in April: “The financial crisis has confirmed the doctrine of hysteresis more strongly than anyone might have supposed.”

New paper shows GFC effect

Now Professor Laurence Ball from John Hopkins University in Baltimore has published a paper on the long-term damage that the GFC has caused in 23 OECD countries.

He measured the effects by comparing the current estimates of potential outputs in each economy published by the IMF and OECD with the path that potential outputs were following in 2007, according to estimates at the time.

Ball found that the losses in potential output by 2015 based on current IMF and OECD forecasts ranged from almost nothing in Australia and Switzerland to more than 30% in Greece, Hungary and Ireland.

The average loss, weighed by economy size, would be 8.4% in 2015.

To put that figure for potential output loss caused by the deviation from the pre-2007 trend, it’s worth noting that Germany accounts for 8.2% of the aggregate economy of the 23 economies in the study.

The total damage from the Great Recession is slightly larger than the loss if Germany’s entire economy disappeared.

If you prefer thinking in dollar terms: for the entire sample, the weighted average of the loss in potential output amounted to 7.2% in 2013, rising to 8.4% in 2015.

Measured in 2015 US dollars, the 8.4% loss for the 23 countries added up to $4.3 trillion.

How did we escape?

So how did Australia avoid this carnage?

According to Professor Ball, Australia was almost unscathed because of factors including fiscal stimulus and strong exports to Asia.

In other words, by going early, going strong and going households plus by being lucky in that China also opted for an expansionary fiscal stance pouring yuan into energy and steel-hungry infrastructure construction.

That expansionary strategy successfully carried China through the GFC. But, it came with a considerable legacy cost in terms of a property bubble inflated by debt courtesy of a lightly-regulated shadow banking system.

From the petro-dollar recessions of Latin America in the 1980s to Japan in 1990 and the Asian contagion of 1997, we have seen how debt–driven recessions struggle to recover compared with inflation or inventory cycle recessions.

The more extended the struggle the more likely it is for hysteresis to be an issue.

In such recessions, the rate of capital accumulation is sharply reduced.

Labour markets are particularly vulnerable often with long-term consequences that are most apparent in declining participation rates.

It is also common to have a slowdown in the growth of total factor productivity as businesses are slow to move to more technologically advanced equipment.

Naturally all of these developments feed into financial markets.

Japan as a case study

Japan since 1990 provides the best case study in the way in which hysteresis can emerge in a weakened economy that provides an ideal habitat.

Professor Ball’s simple model of the power wielded by hysteresis is dependent for its credibility on the official growth estimates of the IMF and OECD.

These have been revised down across most countries of late. If correct, that would make the outlook worse and the potential damage to the global economy all the greater.

As Nobel laureate Paul Krugman wrote last week: “One possibility is that the output gap numbers are wrong; we’re actually having a very hard time figuring how much slack there is.

“Another possibility is that it’s just a coincidence that underlying growth slowed at the same time as the crisis. But if you take the numbers seriously, they do seem to indicate that hysteresis – short-term shocks
quasi-permanently hurt the economy’s potential – is a very big issue.”

This advice is general advice only. It has been prepared without taking account of your objectives, financial situation or needs. Therefore, before acting on the advice, you should contact your Dixon Advisory Adviser to discuss the appropriateness of the advice, having regard to your objectives, financial situation and needs

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Max Walsh

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Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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